Only two weeks ago, the markets were expecting UK rates to peak at 6.25% and for the BoE to hike them from 5% to 5.5% at its August meeting. Now, the market sees rates peaking at 5.75% and the MPC opting for a 0.25% hike next week. Our view has remained the same, namely that rates do not need to rise from 5% but that the MPC will hike by 0.25%. This should be the peak.
With the BoE lacking credibility in the eyes of the market, not helped by its poor communication, it may not feel in a position to lead and thus a subsequent hike cannot be ruled out. Previously I have said the BoE should be able to say rates have peaked when it sees evidence of a softer labour market or that core inflation has peaked. The latter may have already happened, but the BoE may need further evidence to be sure. In June, core CPI (which excludes energy, food, alcohol and tobacco) rose by an annual rate of 6.9% versus 7.1% in May, itself the highest rate since March 1992. The CPI goods annual rate slowed from 9.7% to 8.5%, while the CPI services annual rate eased from 7.4% to 7.2%.
There has already been significant tightening, with policy rates rising from 0.1% in December 2021 to 5% now. Monetary tightening works with a long and variable lag and much of this tightening has yet to feed through. While many savers will benefit from the rise in interest rates, not only will those who are refinancing their mortgage be hit, but so, too, will be large parts of the corporate sector. They will face tougher lending and credit conditions because of the necessary normalisation of monetary policy that has taken place over the last eighteen months.
Other economic indicators, including the current weakness of manufacturing, may argue against further tightening. Also, while the BoE does not mention money in their analysis, they should pay heed to monetary conditions as these, too, would be consistent with an easing of inflation fears.
The inflation cycle
We have read the inflation issue well at Netwealth in recent years. Initially, early in 2021, we argued that inflation would persist, and not be transitory as the BoE believed. We disagreed with the quantitative easing that the MPC unanimously supported then and believed policy rates needed to be higher. Writing a column in The Guardian in December 2021, I highlighted the inflation problem noting that, “monetary policy has gone from being carefree to careless – and it will be a long and painful challenge to restore monetary and financial stability.”
However, we did think inflation would peak far lower than it eventually did. But even so, in The Times annual survey of economists at the beginning of 2022, I was one of only two economists (the other was Charles Goodhart) who thought inflation would peak above 7%. The others expected the peak to be less than that. As energy prices rose, we did increase our inflation forecast.
In the event, inflation peaked at 11.1% in October 2022. Last week’s data showed the headline rate of consumer price inflation (CPI) had reached 7.9% in June. We still expect it to fall significantly, reaching the PM’s target by year-end, and decelerating through the first half of next year. The OBR expects the 2% inflation target to be either undershot or met in future years and this coming week the BoE will unveil its latest economic forecasts. While their recent forecasting record has been poor (this time a year ago they predicted a two-year recession when others did not), this new forecast will provide the market with a fresh benchmark. It may shift market thinking, too, allowing the market to believe the peak in rates may be lower than currently expected.
With oil prices low and market views on rates and yields having already eased in recent weeks, the Bank will be able to factor this into their thinking, too, and their new forecast may actually appear realistic – pointing to a soft-landing for the economy. If so, that would be in line with our thinking, of modest growth and decelerating inflation. Importantly, as inflation decelerates this will boost spending power, helping consumer spending. It is a delicate economic picture as previous tightening weighs against decelerating inflation and a tight labour market, and the evidence that while some people have pockets of savings, the country has suffered a massive cut to living standards because of inflation.
Two key issues
The immediate focus for markets is on where rates will peak. However, attention may need to turn to two issues we have previously highlighted and on which we have taken a strong view.
One is that, in future, policy rates may settle at higher levels than the market previously thought. The challenge here is the groupthink that dominates central banking. Their view is that “r-star”, which is the natural level for policy rates in real terms after allowing for inflation, is close to zero in western economies. But in my view, in future there is a need for policy rates that are positive in real terms.
So, if inflation was three per cent and economic growth two per cent, an r-star of zero would mean policy rates could settle at three per cent (the same as inflation). But a more sensible rate might be five per cent as that would be the rate of growth of nominal GDP (which is inflation plus growth) and thus higher than inflation.
The second is that, after this crisis, inflation may settle at a higher level, say three to four per cent, versus the one to two per cent before. Indeed, it is the persistence of core inflation that is a concern for central banks, and also the future issue is how determined central banks will be in trying to get inflation down to two per cent, if it is seen as settling slightly higher.
Avoid cheap money
Nonetheless, once rates do peak, markets will speculate on the next move being down, albeit this is some time away. Indeed, it is certainly the case that if the BoE or other central banks were to tighten too much, then if growth slows the pressure for rate cuts would return. Yet, in recognising this, there is a difference between tweaking rates from future highs versus aggressive, sustained rate cuts. The latter is not going to happen.
It is important that we do not return to the cheap money policies that prevailed previously as they led to asset price inflation across financial markets and housing, to financial markets not pricing properly for risk, to a misallocation of capital and to an inflationary environment, as evidenced in recent years.
Testifying to the Treasury Select Committee recently I described the UK’s three phases of QE quantitative easing) since 2008 as: the good, the unnecessary and the bad. The first phase, after 2008, was good, preventing depression. The unnecessary was the prolonged period of cheap money up until the pandemic. And the bad was the decision to engage in QE when the pandemic hit.
Clearly one should allow some slack to policy makers for how they reacted when the pandemic hit, as there was so much fear as well as uncertainty. But once it became clear that it was a supply shock and also that fiscal policy was being eased significantly, then monetary policy should have been tightened, not loosened. The correct policy mix necessitated much higher policy rates and no QE.
The good news now is that the first-round effects that triggered inflation have been reversed, namely the supply-side shocks and lax monetary policies. In February 2022, when Russia invaded Ukraine, inflation was already well above its 2% target and rising, increasing from 5.6% in January 2022 to 6.2% in February. Now, it is second-round inflation effects that are the inflation concern with a focus on wage growth and corporate profits.
Wages did not cause this bout of inflation, and the current higher wage demands in the public sector are not inflationary. Wages are catching up, but it is the case that a sustained period of economy-wide wage growth in excess of productivity would point to inflation settling above target in the future.
Importantly, two of the four global influences that have contributed to the low inflation environment over the last quarter century are now reversing. The four disinflationary drivers were: globalisation, low wage share, technology and financialisation. Now globalisation is replaced by fragmentation and friend-shoring, adding to costs, and wage shares are rising, although that is no bad thing especially in the UK. Higher wages may incentivise firms to invest more, both in training and in capital areas such as robotics and technology, too.
Conclusion
Following the 2008 global financial crisis we moved to a cheap money world. This was exacerbated during the pandemic, apart from China and much of Asia where monetary policy was prudent. Now, in the UK and the west, monetary policy is normalising. The implication – whereas previously the BoE was behind the curve – is that decisions on monetary policy now are a more finely balanced judgment call.
We think rates should remain on hold but we expect the BoE to hike this week, by 0.25% and further hikes cannot yet be ruled out. The main focus of financial markets will shift from inflation to growth and then onto debt. For now, and certainly here in the UK, inflation is still the dominant issue.
Please note, the value of your investments can go down as well as up.
